Bubble Meter is a national housing bubble blog dedicated to tracking the continuing decline of the housing bubble throughout the USA. It is a long and slow decline. Housing prices were simply unsustainable. National housing bubble coverage. Please join in the discussion.

Tuesday, September 30, 2008

Larry Summers, Harvard economist and former U.S. Treasury Secretary under Bill Clinton, gives his thoughts on the proposed bailout:

It is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers. ...

Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...

Indeed, in the current circumstances the case for fiscal stimulus — policy actions that increase short-term deficits — is stronger than at any time in my professional lifetime.

In the end, the financial markets did not stand a chance against voter antipathy, partisanship and election year politics.

The defeat of the extraordinary $700 billion financial rescue package represented a perfect collision of the forces of modern politics — a fast-moving Internet campaign, vulnerable incumbents, a weakened and unpopular president, and a roiling presidential campaign — all working against the so-called Masters of the Universe.

Polls showed widespread public opposition to the plan — the biggest federal intervention in financial markets since the Great Depression of the 1930s — and many Republicans saw such an enormous set-aside of taxpayer money as an unnecessary intrusion into free markets. Of the 19 most-endangered House incumbents, 13 voted no. ...

Such a roaring confluence of opposition could only have been overcome with strong party discipline and presidential power. But a weakened and unpopular President George W. Bush and lawmakers forced to weigh the vote against their political careers conspired against success.

Outside Congress, however, furious pressure built up against the bill in e-mail campaigns and on Internet Web sites. The Club for Growth, a conservative free-market oriented group, warned lawmakers that it would count a vote in favor of the legislation against lawmakers seeking the group's support. The Club for Growth is viewed with apprehension by many Republicans because it has been known to support challengers running against party incumbents in primary contests.

Longtime conservative activist Richard Viguerie warned that lawmakers who voted for the rescue package would be targeted for defeat. "Republicans and Democrats alike who support this monstrosity will face the wrath of the voters if they stand side-by-side with predatory politicians and bureaucrats and their greedy friends who got us in this mess," he said.

The opposition on the House floor came from an unlikely coalition of conservatives and liberals. The progressive grassroots group MoveOn.org aired an ad blaming the financial crisis on John McCain and his allies.

All those forces worked against powerful special interests. The U.S. Chamber of Commerce and a diverse group of industry lobbying organizations ranging from the National Association of Realtors to the American Hotel and Lodging Association pressed Congress to back the bill, pointedly noting that they too would consider this a key vote when ranking members.

The vote also represented an extraordinary rejection of Bush, who personally called wavering lawmakers and delivered a last-ditch public appeal Monday morning, as well as Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.

"Despite days of negotiating, this is still the same bailout bill, written by a Wall Street guy with a Wall Street solution to a problem created on Wall Street," said Rep. Mike Rogers, a Michigan Republican. "This bill was still a blank check to Henry Paulson."

I saw Chris Matthews on MSNBC last night berating a Republican congressman who voted against the bailout. Matthews asked the congressman if he was just doing what was politically easy, since he voted the way his constituents wanted instead of the way President Bush wanted. Matthews behaved as if America is a dictatorship rather than a representative democracy.

Congressmen have an ethical responsibility to listen to their constituents. Their loyalty should be to the people, not to the President. If our founding fathers had intended for congressmen to obey the President, Congress and the Presidency would not have been made separate branches of government.

The purchase of a house is the ultimate confidence indicator, and if there's anyone out there with any confidence these days after what the markets and the financial sector have been through, then you're talking about the true eternal optimist.

August existing-home sales dropped a little more than 2%, the National Association of Realtors reported Wednesday, and overall sales are down more than 10% from a year ago.

August sales, though, represent the closing on houses on which a purchase contract had already been signed, meaning the actual decision to buy those houses was made in May or June, before economic events started spinning out of control....

As if those monumental items weren't enough to give potential home buyers the jitters, factor in a deteriorating job market — the economy has lost jobs for the last eight months and unemployment has risen near a five-year high — and house prices that continue to fall in many parts of the country and you understand why the housing market looks like a sunken soufflé. ...

But don't read rebound into those tea leaves. The uncertainty among housing consumers is not abating. And as we watch this week as Washington tries to fashion a bailout for the economy — which may or may not include any actual relief for beleaguered homeowners or any direct shot in the arm for home sales or any mechanism to shore up home prices — we are only likely to grow more afraid, not less.

Folks forced into the housing game in the last quarter of the year better be prepared for some rough stuff. For everyone else, watching the carnage from the stands will be the safest vantage point.

Zillow.com shows that after peaking in late 2005–early 2006, home prices have been falling in Northern Virginia over the past two-and-a-half years. Note that the prices shown are not adjusted for inflation.

The VIX index, shown above, uses options prices to measure expected stock market volatility over the next 30 days. It closed yesterday at an extraordinarily high 46.72. Meanwhile, the TED spread, the difference between the interest rates on inter-bank loans and T-bills, stands at an extraordinarily high 325 basis points.

Warren Buffett has said, "you should get greedy when others are fearful and fearful when others are greedy." If he is right, then this is the time to get greedy. There is no doubt that most everyone else is fearful.

Monday, September 29, 2008

Myth #1: Ordinary taxpayers would have to pay for the Troubled Asset Relief Program (TARP).

Myth #2: It would reduce the value of the dollar.

The truth:The government probably wouldn't have to print money, raise taxes, or go into deeper debt to do it. Instead, the government would be sucking in $700 billion of mortgage bonds while spitting out $700 billion of Treasury bonds. It would simply trade one asset for another of equivalent market value.*

The government probably wouldn't be giving Treasury bonds directly to banks in exchange for mortgage bonds. Instead, it would likely pay cash for the mortgage bonds and then sell an equivalent amount of Treasury bonds onto the open market. However, there would be no significant change in the monetary base.

Warren Buffett has pointed out that current buyers of mortgage-backed securities are expecting to earn an annual rate of return of at least 15%. He said that the government should be able to earn at least 10%, as a conservative estimate.*

As of Friday, 30-year Treasury bonds were yielding about 4.4%. If Buffett is right, this means that over the long run, the government should be able to earn a net annual rate of return of 5.6-10.6%. With $700 billion invested, this translates to a gain of $39 billion–$74 billion per year.

Of course, there is risk of a loss—even a big loss. However, the odds are in the government's favor.

If this is a boon for the government, why would banks go for it? It's simple: weaker banks would be giving up higher returns in the long run for greater stability in the short run.

Update: I should have said the government won't have to go into deeper net debt. It would go into deeper debt, but it would use the debt to buy assets of the same value. This is a lot different than going deeper into debt to finance current spending, as the government usually does.

* This assumes the government buys at market prices, rather than following Bernanke's stupid idea of overpaying.

Stocks skidded Monday afternoon, with the Dow's nearly 778-point drop being the worst single-day point loss ever, after the House rejected the government's $700 billion bank bailout plan.

Stocks tumbled ahead of the vote and the selling accelerated on fears that Congress would not be able come up with a fix for nearly frozen credit markets. The frozen markets mean banks are hoarding cash, making it difficult for businesses and individuals to get much-needed loans.

According to preliminary tallies, the Dow Jones industrial average lost 777.68, surpassing the 684.81 loss on Sept. 17, 2001 - the first trading day after the September 11 attacks. However the 7% decline does not rank among the top 10 percentage declines.

The Standard & Poor's 500 index was down 8.7% and the Nasdaq composite 9.1%.

Legendary investor Warren Buffett warned Congressional leaders Saturday night of "the biggest financial meltdown in American history" if they did not act to secure the financial system.

Buffett, by telephone, was consulted by lawmakers who were in marathon talks on Capitol Hill to forge a deal on the administration's $700 billion economic bailout plan, according to two sources.

One lawmaker in the negotiations said that the participants called Warren Buffett to get his help in gauging potential market reaction. ...

Earlier in the week, Buffett also warned that the financial crisis is "everybody's problem," not just Wall Street's. The potential collapse of financial institutions would cause industry to grind to a halt, he told CNBC Wednesday, and could have "gummed up the economy."

Citigroup will buy the banking operations of Wachovia in a deal brokered by the Federal Deposit Insurance Corp, the FDIC said on Monday. ...

Under the deal, struck in consultation with the Federal Reserve, the Treasury and President Bush, Wachovia depositors will be fully protected, and no cost to the Deposit Insurance Fund is expected, the FDIC said.

"Wachovia did not fail; rather, it is to be acquired by Citigroup Inc on an open bank basis with assistance from the FDIC,'' the agency said in a statement on its website.

Shares of Wachovia, the sixth-biggest U.S. bank by assets, tumbled more than 80 percent in pre-market trading to below $2 per share. ...

The FDIC said it would share losses with Citi on certain Wachovia loans.

"The FDIC has entered into a loss-sharing arrangement on a pre-identified pool of loans,'' the agency said. "Under the agreement, Citigroup will absorb up to $42 billion of losses on a $312 billion pool of loans."

"The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.'' ...

"One thing that Citigroup has been wanting to do for a while is to expand its retail operations because they are in very limited areas, so this would basically allow them to do that,'' said Rose Grant, managing director of Eastern Investment Advisors in Boston.

Citigroup will buy the bulk of Wachovia's assets, including five depository institutions, and assume its senior and subordinated debt. Wachovia will retain ownership of AG Edwards, a big retail brokerage it bought a year ago, and its asset-management division, Evergreen.

A bidding war for Wachovia has erupted between banking giants Citigroup and Wells Fargo, according to a published report Sunday night. ...

Rumors of deal talks arose on Friday as published reports said that Wachovia was considering a deal with Citigroup, Spain's Banco Santander or Wells Fargo.

Sunday's report in The Times added that the Federal Reserve and Treasury Department were also participating in the discussions, but that the government is refusing to help bidders by guaranteeing a part of Wachovia's assets the way it did for Bear Stearns in March when it was sold to JPMorgan Chase.

The government was also not ready to take over Wachovia the way it did Washington Mutual last week, The Times reported, unless its financial position deteriorates more rapidly.

Timing for a deal was not clear, and the talks could extend beyond Sunday night, The Times said.

Wachovia shares were hit particularly hard on Friday — the stock lost nearly a third of its value.

Though the stock closed at $10 on Friday, Citigroup and Wells Fargo are unlikely to bid more than a few dollars a share for Wachovia, according to The Times.

Also unclear, The Times said, was whether the banks would bid for all of Wachovia or pieces. Wachovia's retail banking operations would help Citigroup and Wells Fargo expand their branch networks, The Times said.

It is foolish for Citi and Wells to get into a bidding war over America's fourth largest bank. Instead, they should work together to split up Wachovia.

Neither Citigroup nor Wells Fargo are strong enough to take over Wachovia on their own. Both are damaged due to the mortgage meltdown, although Citi is much more damaged than Wells. On the other hand, Wells Fargo is much smaller than Citi. In fact, Wells Fargo is smaller than Wachovia. This puts both banks in a bad spot with respect to such a large acquisition.

Rather than either one of them trying to bite off more than they can chew, they should split Wachovia in two. Wells Fargo should take the western half and Citigroup should take the eastern half. This way, each bank can be the dominant player in parts of the country where they are already strong, and they can benefit from the network effects of being the dominant bank in their respective regions.

By working together, not only would they avoid over-stretching themselves, but they would also be able to buy at a lower price.

Fortis, the largest Belgian financial-services firm, received an 11.2 billion-euro ($16.3 billion) rescue from Belgium, the Netherlands and Luxembourg after investor confidence in the bank evaporated last week.

Belgium will buy 49 percent of Fortis's Belgian banking unit for 4.7 billion euros, while the Netherlands will pay 4 billion euros for a similar stake in the Dutch banking business, the governments said in a statement late yesterday. Luxembourg will provide a 2.5 billion-euro loan convertible into 49 percent of Fortis's banking division in that country.

Fortis is the largest European firm so far caught up in the global financial crisis.... Fortis dropped 35 percent last week in Brussels trading on concern the company would struggle to replenish capital depleted by the 24.2 billion-euro takeover of ABN Amro Holding NV units and credit writedowns.

"Confidence in Fortis needs to be restored,'' said Corne van Zeijl, a senior portfolio manager at SNS Asset Management in Den Bosch, the Netherlands, who oversees about $1.1 billion and owns Fortis shares.

Fortis plans to sell its stake in ABN Amro's consumer banking unit, though a buyer wasn't identified. Fortis joined with Royal Bank of Scotland Group Plc and Spain's Banco Santander SA last year to buy Amsterdam-based ABN Amro for 72 billion euros, just as the U.S. subprime mortgage market collapsed.

Alistair Darling, the Chancellor, will announce on Monday that the Government is taking over the bank’s mortgages and selling off the savings business and the branches. Savers are reassured that their money is safe although people owning shares in the bank will lose out.

The Government may merge the bank, which has mortgages worth more than £40 billion, with the nationalised Northern Rock. Every taxpayer in Britain will be exposed to the equivalent of £5,500 in mortgage debt as a result.

Sunday, September 28, 2008

So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can(1) conduct reverse auctions and suchlike(2) buy directly — but only if it gets equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

"By many metrics stocks are priced as low as they have been for 25 years," says Peter J. Tanous, president and director of Lynx Investment Advisory of Washington, D.C. "If you still believe in the future of this country, it is very possible that in five years from now you will be able to look back and say, 'Wow, what a buying opportunity.' "

Saturday, September 27, 2008

In the debate last night, Barack Obama asked a good question about the present financial crisis but then gave an answer that is, at best, incomplete:

The question, I think, that we have to ask ourselves is, how did we get into this situation in the first place? Two years ago, I warned that, because of the subprime lending mess, because of the lax regulation, that we were potentially going to have a problem and tried to stop some of the abuses in mortgages that were taking place at the time....we're also going to have to look at, how is it that we shredded so many regulations? We did not set up a 21st-century regulatory framework to deal with these problems. And that in part has to do with an economic philosophy that says that regulation is always bad.

The main problem, we are led to believe, was a Republican ideology of unfettered capitalism that led to insufficient government involvement in the financial system.

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation iseasing the credit requirements on loans that it will purchase from banks and other lenders....Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.

Back on August 4, I pointed out that Bubble Meter was ranked as #41 among economics blogs. Our ranking has changed a bit since then. Apparently, Bubble Meter is now ranked at #13.

I'll admit that I'm a bit surprised by this, since we haven't had a surge of people commenting on our blog posts. I'd love to crack the top 10, so please link to Bubble Meter and tell your friends about us. And above all, please leave comments. That's the only way we know if readers are interested in what we say.

If your regularly-updated econ/finance/housing blog is not listed at right, please add a link to it in the comments. If David likes it, perhaps he'll update the blogroll. I have no control over the blogroll. I'm just a lowly cob logger.

For the record, I support a bailout, but with $700 billion on the line I think it is extremely important that it is done right. Several University of Chicago economists have proposed improvements to the plan.

I also don't think the bailout will solve the financial crisis, but I think it will help. Bernanke and Paulson (or their successors) will likely be going back to Congress begging for more help in the future.

To put things in perspective, $700 billion is about $2,304 for every man, woman, and child in America. Hopefully, however, the Treasury would be buying assets worth roughly the same amount, so it wouldn't be $2,304 out of pocket for American taxpayers.

The Paulson bailout isn't enough. It is ridiculous that the government is planning to spend $700 billion to bail out the financial system when bank regulators haven't even taken the simple step of requiring banks to preserve capital by suspending dividend payments.

Let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues.... As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information ... makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. ... But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

Many seem taken aback by the depth and severity of the current financial turmoil. I was among several economists who saw it coming and warned about the risks.

There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely. ...

One can say the Fed failed twice, both as a regulator and in the conduct of monetary policy. Its flood of liquidity (money made available to borrow at low interest rates) and lax regulations led to a housing bubble. When the bubble broke, the excessively leveraged loans made on the basis of overvalued assets went sour.

For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail?

First, key regulators like Alan Greenspan didn't really believe in regulation; when the excesses of the financial system were noted, they called for self-regulation — an oxymoron.

Second, the macro-economy was in bad shape with the collapse of the tech bubble. The tax cut of 2001 was not designed to stimulate the economy but to give a largesse to the wealthy — the group that had been doing so well over the last quarter-century.

The coup d'grace was the Iraq War, which contributed to soaring oil prices. Money that used to be spent on American goods now got diverted abroad. The Fed took seriously its responsibility to keep the economy going.

It did this by replacing the tech bubble with a new bubble, a housing bubble. Household savings plummeted to zero, to the lowest level since the Great Depression. It managed to sustain the economy, but the way it did it was shortsighted: America was living on borrowed money and borrowed time.

Finally, at the center of blame must be the financial institutions themselves. They — and even more their executives — had incentives that were not well aligned with the needs of our economy and our society.

They were amply rewarded, presumably for managing risk and allocating capital, which was supposed to improve the efficiency of the economy so much that it justified their generous compensation. But they misallocated capital; they mismanaged risk — they created risk.

They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.

Friday, September 26, 2008

What is my opinion about all this? I am of two minds about the complex situation we find ourselves in.

On the one hand, I share many of the concerns of the letter signers and other critics of the Treasury plan.

On the other hand, I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Recently, a lot of Democrats and left-leaning journalists have been blaming the 1999 repeal of the Glass-Steagall Act for today's financial problems. I believe they are wrong. Their reasoning is based on the post hoc ergo propter hoc ("after the fact, therefore because of the fact") fallacy. They reason that since Glass-Steagall was repealed in 1999 and we have a credit crisis today, the repeal of Glass-Steagall caused the credit crisis.

The truth is that there were far more bank failures a decade prior to the the repeal of the Glass-Steagall Act than there are today, even though today's financial crisis is much worse.

Instead, today's financial crisis is due to the decline of a housing bubble. The housing bubble was caused by unreasonably low Fed interest rates, a savings glut overseas, and the get-rich-quick mentality of home buyers.

While many Democrats and journalists are wrong about the repeal of Glass-Steagall, Bill Clinton is right:

One policy Clinton said he doesn't regret is his repeal of the Glass-Steagall Act in 1999, which, for the first time since the Depression, allowed commercial banks to engage in investment banking activities. Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week. "In the case of the current crisis, I believe the bill I signed allowed Bank of America to take over Merrill Lynch," he said.

If Glass-Steagall were still law, a troubled Bear Stearns would not have been allowed to merge with JPMorgan. Also, Goldman Sachs and Morgan Stanley would not have been allowed to become commercial bank holding companies. The repeal of Glass-Steagall has been a savior, not a villain.

August sales came in at a seasonally adjusted annual rate of 460,000, the Census Bureau report showed, down 11.5% from a revised 520,000 in July. The reading was well below the consensus forecast of 513,000, according to economists surveyed by Briefing.com.

The rate of sales was down 24.5% from a year earlier. Sales were at their lowest pace since January 1991, when the first Gulf War started, and the economy was near the bottom of a recession and undergoing an oil price shock. ...

Sales fell as prices continued to drop. The median price of a new home sold in August was $221,900, down 5.5% from $234,900 in July and down 6.2% from $236,500 a year earlier. Prices for new homes on the market were at their lowest level since September 2004.

This decline probably doesn't accurately capture the weakness in prices for new homes, as about three out of four builders have reported having to pay buyers' closing costs or offer other incentives such as expensive features for free in order to maintain sales.

Prices have been driven down by the glut of new homes on the market.

The report showed 166,000 completed new homes available at the end of the month, bringing total inventory — including new homes under construction and not yet started — to a seasonally adjusted 408,000, equal to 10.9-month supply. That's up from a 10.3 month supply in July.

Sales of existing homes fell in August, according to the latest reading on the battered housing market released Wednesday by an industry trade group.

The National Association of Realtors reported that sales by homeowners sank in August to an annual pace of 4.91 million, down 2.2% from the revised July reading of 5.02 million. It was the ninth month in a year in which the sales pace fell.

August sales were down 10.7% from a year earlier. ...

Meanwhile, the median price of a home sold during the month — including single-family homes, townhomes, condominiums and co-ops — fell 9.5% to $203,100 from $224,400 a year ago. Before the start of the current housing slump, it had been 11 years since prices fell on a year-over-year basis.

The House Republican Study Committee is set Tuesday to officially unveil its proposal to address the financial crisis through a “market-based” approach.

The conservative group, which has strong objections to a federal bailout that would cost hundreds of billions of dollars, is touting its plan as a “true alternative” to Treasury Secretary Henry Paulson’s plan to rescue the financial markets.

The RSC plan, which will be unveiled at noon, calls for a two-year suspension of the capital gains tax.

“By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy,” an outline of the proposal said. “After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains.”

The group’s plan would also transition Fannie Mae and Freddie Mac to private companies “in a reasonable time,” seeks to stabilize the dollar, and would “suspend the mark-to-market regulatory rules for long-term assets.”

[The plan] of the House Republican Study Committee, seems to be a joke. It calls for a two-year suspension of the capital gains tax to "encourag[e] corporations to sell unwanted assets." But the toxic mortgage securities clogging up bank balance sheets are worth less now than when they were acquired. Meaning that no capital gains tax would be owed on them anyway. If you repealed the tax, banks would have even less incentive to sell them because they wouldn't be able use the losses to offset capital gains elsewhere.

In short, suspending the capital gains tax when everyone's sitting on losses is harmful.

Stabilizing the dollar would also be harmful. A nation's currency should fall during times of economic weakness, because a falling currency stimulates the economy.

I hypothesized yesterday that mark-to-market accounting may be causing a vicious cycle in the credit markets. If this is correct, their plan to suspend mark-to-market accounting for long-term assets might help in the short-run. The problem is that the alternative is "mark-to-make-believe," which in the long run would give financial institutions too much leeway in making up unrealistic numbers.

The housing market in almost all bubble markets is not and will not recover in the current half of 2008. The housing cheerleaders, Lawrence Yun said in July 2008:

"I think we are very near to the end of the housing downturn," (AP News).

The just released New Home Sales Report shows a months supply of 10.9 months (quite high). And new home sales for August 11.5 percent below the revised July rate.

Historically, most housing busts in the United States lasted 3 - 8 years. Since this housing boom was much larger then previous booms, the bust is likely is to last on the longer side. However, some say because of much better access to information (Internet, more statistics etc) the bust is happening faster. Since, late 2005 / early 2006 was the peak, this bust has lasted about 3 years. Likely bottoms, in most bubble markets, should occur between late 2009 to 2012.

Washington Mutual, the giant lender that came to symbolize the excesses of the mortgage boom, was seized by federal regulators on Thursday night, in what is by far the largest bank failure in American history. ...

Regulators simultaneously brokered an emergency sale of virtually all of Washington Mutual, the nation’s largest savings and loan to JPMorgan Chase for $1.9 billion, averting another potentially huge taxpayer bill for the rescue of a failing institution. ...

Customers of Seattle-based WaMu, with $307 billion in assets, are unlikely to be affected, although shareholders and some bondholders will be wiped out. WaMu account holders are guaranteed by the Federal Deposit Insurance Corporation up to $100,000.

By taking on all of its troubled mortgages and credit card loans, JPMorgan will absorb at least $31 billion in losses that would normally have fallen to the F.D.I.C.

JPMorgan Chase, which acquired Bear Stearns only six months ago in another shotgun deal brokered by the government, is to take control Friday of all of WaMu’s deposits and bank branches, creating a nationwide retail franchise behemoth that rivals only Bank of America. But JP Morgan will also take on Washington Mutual’s big portfolio of troubled assets, and plans to shut down at least 10 percent of the combined company’s 5,400 branches in markets like New York and Chicago, where they compete. The bank also plans to raise an additional $8 billion by issuing common stock on Friday to pay for the deal.

Washington Mutual is by far the biggest bank failure in history, eclipsing the 1984 failure of Continental Illinois National Bank and Trust in Chicago, an event that presaged the savings and loan crisis. IndyMac, which was seized by regulators in July, was one tenth the size of WaMu.

I was very skeptical of the claim that WaMu is the biggest bank failure in U.S. history, but it seems that this might actually be true. Journalists usually fail to adjust for inflation. However, even after adjusting for inflation, WaMu is much larger than Continental Illinois National Bank and Trust.

Journalists also rely on the FDIC for their bank data, which means they don't count bank failures prior to 1934, but most Great Depression bank failures were small banks. The most notable bank failure of the time was the December 11, 1930 collapse of the New York Bank of the United States, which had about $2.1 billion in reserves, measured in 2008 dollars.

Lehman Brothers was far larger than WaMu (measured in assets), but investment banks are generally not considered banks in the traditional sense.

Thursday, September 25, 2008

Assuming this bailout (Troubled Asset Relief Program) becomes law, I predict Warren Buffett will be asked to run it, pro bono.* With $700 billion of American taxpayer money at stake, politicians will have an exceptionally strong incentive to recruit the absolute best person for the job. Warren Buffett is the obvious guy to pick. Also, this is the year that both presidential candidates are advocating national service—putting country before self. Asking the world's greatest investor to put country before self isn't too much of a stretch.

I estimate the probability that Buffett will be asked to do it is less than 50%, but far higher for him than for any other individual alive.

The credit crisis that began last summer has intensified so much that any U.S. government bailout plan has "little hope" of improving core fundamentals over the near and medium term, said analyst Meredith Whitney. ...

"Since the onset of the credit crisis, over $2 trillion less liquidity has flown through the U.S. domestic capital markets than during ... a year prior," Whitney said.

"With that much less available capital, both consumers and corporations have and will spend less," she added. ...

"Credit market disruption has had underappreciated consequences on the economy ... what started last summer has accelerated and intensified so much so that we believe any government bailout plan has little hope of improving core fundamentals over the near and medium term," Whitney said. ...

Oppenheimer's Whitney expects the country's GDP to take a hit from likely moves by state governments to cut costs.

Given that over 12 percent of the U.S. GDP is driven by state and local government spending, and with many key states' 2009 budgets being under-funded, governments will be forced to cut costs and this will weigh significantly on GDP, she said.

Whitney said home prices were not close to bottoming and expects prices to ultimately be at least 25 percent lower from current levels. She also sees further declines in homeownership rate.

The unemployment rate, which is up over 40 percent year-on-year in key states, is "headed materially higher," Whitney said.

Home prices in July fell 5.3% compared with a year ago, a government agency said Tuesday, and have now receded to October 2005 levels.

The home price index was down 0.6% from June on a seasonally adjusted basis, according to the Federal Housing Finance Agency.

The nationwide decline in home values coupled with reckless lending standards are the driving forces behind rising mortgage defaults and foreclosures, and the credit crisis that has shaken Wall Street to its core.

According to the competing S&P/Case-Shiller Home Price Index, house prices have already fallen to mid-2004 levels.

as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.

In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own.

Greg Mankiw is right to be suspicious. It is very presumptuous of government officials to assume they know the proper value of mortgage-backed securities better than the free market does—especially since Bernanke and Paulson have been consistently wrong about the housing market.

However, Warren Buffett's comments yesterday seem to support a hypothesis that I've had in my head for a while now. Buffett thinks the government will get a good rate of return. This suggests that Buffett, himself, thinks MBS's are underpriced.

My hypothesis is this: Even if the mortgage-backed securities would be a good investment in the long run, highly-leveraged financial institutions can't risk buying them if the price continues dropping dramatically in the short run. With mark-to-market accounting, the declining prices could cause any highly-leveraged buyer to find itself insolvent in the short run, even if it is holding assets that will pay off in the long run.

The problem with MBS's is that the only natural buyers of them are highly-leveraged financial institutions. Ideally, unleveraged sovereign wealth funds could swoop in and purchase MBS's on the cheap, but while the world's sovereign wealth funds are flush with cash, they are not sophisticated investors with the courage and instinct to buy undervalued assets during a panic. Thus, the only solution for this problem is for the U.S. government to essentially establish its own sovereign wealth fund, and buy up the undervalued assets. (Investors like Buffett are puny compared to the size of the market.)

In the meantime, there is no natural buyer of these assets that can afford to buy them. Since the price of MBS's is determined at the margin, every time a financial institution tries to deleverage by selling MBS's, it forces all other financial institutions to take losses. This in turn forces them to deleverage by selling off MBS's, thus creating a vicious cycle. The market is not being irrational; the market is being forced to deleverage. The goal of America's sovereign wealth fund (the Troubled Asset Relief Program) is to stop the vicious cycle.

A far cheaper solution than this bailout would be for the U.S. to abolish mark-to-market accounting, but that would likely create more problems than it solves.

The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work. So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.

Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.

That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. It’s more or less what would happen with the Dodd plan, which would buy bad debt but get equity warrants that depend on the later losses on that debt.

But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.

It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

So, three points:

1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.

2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?

3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.

Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

In a long interview uninterrupted by commercials on CNBC this morning, Warren Buffett voiced his support for Treasury Secretary Paulson's proposed bailout. He also said the U.S. government will make a very good profit on the deal (15%+ rate of return), if it buys at market prices.

Fed Chairman Ben Bernanke stupidly suggested yesterday that the government should buy at significantly above market prices. Buffett said that is not a good idea.

Buffett didn't mention this, but I should point out that if the government follows Bernanke's stupid idea and pays above market prices, it would remove less bad debt off of bank balance sheets than if it paid market prices. (The higher the price, the less you can buy.) Bernanke needs a refresher course in microeconomics, since he's suggesting paying more than the equilibrium price.

Buffett also said that President Obama or President McCain should keep Hank Paulson as Treasury Secretary for the first year of their presidency. (I think Obama could probably do quite well with NJ Governor Jon Corzine as Treasury Secretary, if he wanted. Jon Corzine, a Democrat, was Paulson's predecessor as CEO of Goldman Sachs.)

While on the topic of the bailout, let me point out that Carnegie Mellon University economist Allan Meltzer has his own proposal:

if they're going to do something, then what they ought to do is make loans, which the financial institutions have to repay with interest. And if you think — that's an idea which the Chileans have used in a bigger crisis than this for them in 1982, and it worked for them. People paid back the loans. They weren't allowed to pay dividends until they repaid the loans. They weren't allowed to take bonuses until they repaid the loans. I think that's the way — if we're going to do this, then that's the way we should do it.

Somehow, I doubt that if the government follows Meltzer's idea it will earn a 15%+ rate of return. However, I do like the idea of prohibiting dividend payments until the credit crisis has passed.

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

Tuesday, September 23, 2008

Today is a very special day! Today is the 10th birthday of the Wall Street bailouts. It was ten years ago today, on September 23, 1998, that the Federal Reserve bailed out Long Term Capital Management. MarketWatch takes us on our joyful 1998 flashback:

LTCM was a hedge fund run by former Salomon Brothers bond whiz John Meriwether and a half dozen other traders. They raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built on leverage, when the bets turned bad and lenders started asking for their money in the summer of 1998.

LTCM was strapped for cash. So, rather than unwind its positions and send the market into turmoil, the Federal Reserve Board of New York organized a $3.75 billion bailout paid for by Wall Street banks. The cash allowed LTCM to meet its obligations as it unwound its trades.

Maybe it's because the numbers seem small by today's standards, but LTCM caused a lot of anxiety at the time. The day after the bailout was announced, the Dow Jones Industrial Average fell 2%, mostly because investors feared the banks would lose their investment. The fall was followed by another 3% drop two trading days later when investors worried the Fed didn't do enough.

Flash forward to 2008. ... You can't blame Rick Wagoner at General Motors or Glenn Tilton at UAL Corp. for passing the hat to Uncle Sam. These CEOs have seen what a little government intervention can do, whether it be banning naked short selling for a few bank stocks or propping up the entire mortgage banking industry with billions in backing.

The taboo against bailouts has been broken. Now the problem is that everyone is rushing the government at the same time. Wall Street firms ran up risk for a decade after the LTCM bailout precisely because there was a bailout.

The unwritten message, what the bankers call moral hazard, was simple: come a crisis, the government will do everything it can to avoid a collapse.

The Fed chose not to worry about moral hazard then, because it felt the immediate problem was far more important than any increased financial risk-taking it might encourage in the future. Such short-term thinking only causes greater problems in the long run. The Federal Reserve and the U.S. Treasury are again making short-term decisions without any regard to the long-term consequences.

There is a new auction of bank-owned homes coming up in the Washington, D.C. area in early October. The homes up for auction are open for inspection this weekend. A few months ago when I last saw an auction advertised, they were all P.O.S. homes. This time, there seem to be some nice ones available.

What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

I’ve had more time to read the Dodd proposal — and it is a big improvement over the Paulson plan. The key feature, I believe, is the equity participation: if Treasury buys assets, it gets warrants that can be converted into equity if the price of the purchased assets falls. This both guarantees against a pure bailout of the financial firms, and opens the door to a real infusion of capital, if that becomes necessary — and I think it will.

Can this be done? Can the Paulson juggernaut be stopped? I’m starting to think yes. Paulson displayed a lot of arrogance here — he basically marched in and said Daddy knows best, don’t worry your pretty little heads about the details. He offered no, zero, zilch explanation of how the plan was supposed to work — just “it’s a crisis and we need to act now.” And he overreached, especially with that demand for immunity from any review.

Now we’ve had a lot of pushback from economists and financial analysts, and the realization has sunk in that this particular daddy has shown very little sign of knowing best. So there’s a real chance to do something quite different.

Monday, September 22, 2008

"A 2004 photograph from a report by the Homeownership Alliance, an advocacy group for Fannie Mae and Freddie Mac, shows John McCain with Ken Guenther, a former chairman of the group, left, and David Lereah of the National Association of Realtors." NYTimes: Loan Titans Paid McCain Advisor Nearly $2 million

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Why are government regulators allowing financial institutions to pay out dividends during a financial crisis? By paying out dividends, banks are reducing their capital at a time when they should be doing everything they can to preserve capital. I suggest three new regulatory rules, one temporary, two permanent: 1) All financial institutions must suspend dividend payments during this financial crisis. 2) Any time a regulated financial institution is unprofitable, it must suspend dividend payments until profitability is restored. 3) Regulated financial institutions may not pay out quarterly dividends that are greater than quarterly earnings.

If a bank is actually healthy, suspending dividend payments doesn't mean shareholders won't get their money. It just means they will have to wait for it. The money can simply be held on the books until the financial crisis or unprofitable period has passed, and then be paid out to shareholders as an extra-large dividend when the rough period has passed. If a bank is actually unhealthy, the retained capital reduces the probability of a bank failure, which would be a benefit to shareholders.

Allowing financial companies to pay out dividends to shareholders during a financial crisis is reckless, period. The Federal Reserve and other regulators are still failing to do their job competently.

For starters, let's look at the objection of Princeton University economist Paul Krugman:

I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.

As I posted earlier today, it seems all too likely that a “fair price” for mortgage-related assets will still leave much of the financial sector in trouble. And there’s nothing at all in the draft that says what happens next; although I do notice that there’s nothing in the plan requiring Treasury to pay a fair market price. So is the plan to pay premium prices to the most troubled institutions? Or is the hope that restoring liquidity will magically make the problem go away?

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

And there’s no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.

I hope I’m wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.

Sunday, September 21, 2008

Henry Paulson and Ben Bernanke have saved us, for now, from a market meltdown — but at the cost of allowing the folks who caused the current crisis to keep ducking reality. ...

The Treasury secretary and Federal Reserve chairman have spent September dashing off blank check after blank check in a bid to quell turbulent markets. ...

Ultimately, what could prove to be the most expensive aspect of the bailout spree is the message the government is sending to firms in which the market has lost confidence. Prudent management, it seems, will be punished, while the status quo — however unhealthy — must be maintained at all costs.

The strong stock-market rally of the past two days aside, intervention that fails to foster a shakeout of weaker firms will only delay the reckoning that must occur before a sustainable economic recovery can take shape.

"We continue to believe that the financial sector is in need of massive consolidation because the sector simply has too much lending capacity left over from the credit bubble," Merrill Lynch investment strategist Rich Bernstein writes Friday. "History shows well that consolidation is the primary driver of post-bubble economies." ...

Though the free fall in financial shares over recent weeks wasn't pretty to watch, it had the sanguine effect of forcing businesses with questionable fundamentals to confront an uncertain future. ...

But for the rest of us, the feds' rush to defend teetering financial firms only defers the tough decisions that will need to be made before this crisis subsides — at the expense, perhaps, of repeating Japan's so-called lost decade of economic stagnance after its property bubble collapsed around 1990.

History shows that setting up bad banks without forcing financial firms' managers to confront their problems won't solve anything.

"This seems to us," Bernstein writes, "to be a very Japanese approach to solving a credit crisis."

Fortune Magazine obviously disagrees with The Wall Street Journal about whether we're repeating Japan's mistakes. We don't need to keep guessing who is right. In time, we'll all know the answer.